Description

This write-up is pitching the new IHS Markit (INFO) / S&P Global (SPGI) combination as a long. I prefer to play this through INFO because it trades at a 4% deal discount to SPGI, despite minimal regulatory risk. INFO also trades 7% below its pre-announcement level, meaning there is unlikely to be much downside if the deal were to not close. The deal still requires majority shareholder approval from both SPGI and INFO shareholders

Until recently, SPGI wasn’t much of a contrarian or value play that was deserving of a writeup on VIC. The last 2 years, the main problem I have had in managing our clients’ portfolio is that every quality company (high ROIC, long growth runway, stable earnings, proven management team) has gone to valuations that are hard to justify. I’d either had to get comfortable holding 40-50x P/E stocks, or see the quality of average business in the portfolio deteriorate. I find SPGI / INFO an attractive retirement portfolio stock where valuation still leaves plenty of near-term (3 year) upside. I estimate a 62-73% return in 3 years, or a 17-20% IRR.

The long thesis is based on:

-        A long growth runway of double digit earnings growth.

-        A 2021 P/E of ~27x, despite minimal debt (1x Net Debt / EBITDA)

-        A merger between INFO and SPGI that seems disliked by both shareholder bases. SPGI shareholders believe they owned the best assets and any sort of merger is di-worsification. Meanwhile INFO shareholders believe they are giving up control for only a 5% premium. However, INFO CEO and Markit founder Lance Uggla owns 110m USD of INFO shares and is willing to exchange this into shares in the merged entity without having shopped around and for only a 5% premium. He’s also giving up his lucrative position as CEO after a 1 year transitionary period. The only logical explanation is that he sees significant value in potential synergies when merging with SPGI.

-        SPGI only paid a 2b USD premium, for 680m USD in expected annual synergies. Given the price correction since the deal got announced, new investors effectively get both companies at a discount and any synergies for free.

-        As I will discuss, there are qualitative arguments to make why synergy expectations are reasonable.

-        A 4% deal discount is thrown into the mix when buying INFO.

-        The company is under-levered at about 1x Net Debt / EBITDA, while targeting 2-2.5x. Even though capital returns are targeted at only 85% of FCF, there is the potential to deploy or return 14b USD (FCF generation) + 10b USD (extra debt capacity as EBITDA grows and leverage increases) until 2023, or about 22% of today’s combined market cap.

Markit was written up by runner in 2015 and McGraw-Hill (the former SPGI) was written up several times, last by JCOviedo in 2013. Both do a very good job explaining the business. I will talk briefly about the different businesses, mainly to show how I think about growth potential of each business.

Business

-        Ratings (30% of revenue).

o    Duopoly with Moody’s (together 80% market share) and to a lesser extent Fitch (top 3 has 93% market share). Non-rated bonds end up paying ~30 bps more in interest than rated bonds per year. The one-time issuance fee pocketed by SPGI or MCO is ~6-7bps. There is also a small monitoring fee. Value captured vs value added is small, which leaves the ability to increase prices.

o    The way I think about growth is

§  Nominal GDP+ growth of >4% in developed markets, as long as credit as a % of GDP stays constant or grows. USD debt outstanding has been growing at a 8-9% CAGR from 1980-2019. The business automatically has a built-in inflation hedge.

§  +1ppt because of disintermediation of banks as bonds replace bank loans.

§  1-4% pricing. SPGI only captures a small part (7bps) of the value they deliver (30bps per year) and they claim they have been raising prices by 3-4 ppts each year. However, when looking at historic data (8-9% revenue CAGR – ~5% nominal GDP growth – 1% from bank disintermediation) I think 1-3% is more accurate.

§  Non-quantifiable growth from new initiatives, predominantly ESG ratings.

o    49% of revenues comes from a recurring surveillance fee (MCO is 40%). The other half also has a level of predictability as it is a function of a) refinancing and b) M&A activity. The most recent bear case on the rating agents was that there was a pull-forward of refinancing activity in 2020. SPGI expects new issue volumes to drop by 3% in 2021 (while nothing that this does not mean revenue would drop 3%). This comes after 15% growth in 2019 and a guided 13% growth in 2020. This kept most short term focused sell side firms cautious on SPGI. Looking beyond 2021, refinancing needs should grow, simply because debt issuance in the last 3-10 years has been growing every year and this debt will need to be rolled over.

o    I expect ESG ratings to be equally important in the future for bond issues. Credit ratings give bond issuers a 30bps cost advantage and I’m sure the cost advantage of being rated as ‘green’ will be significant as well. How else would a bond get its stamp of approval to end up in an S&P green bond index? I think MCO and SPGI will be dominant in this market as well, as they already have the necessary relations with every treasury department, although the competitive field is slightly different and includes MSCI. SPGI also owns sustainability data on 4700 companies through their acquisition of RobecoSAM.

o    I think the fact that both SPGI and MCO messed up in 2008 and they’re now several times larger and more important validates their importance to the financial markets. Important for us, the exposure to structured products (which is the most cyclical) is down to only 11% at SPGI (or 15% at MCO). 

-        Indices (S&P Dow Jones Indices, only 73% owned) + IHS Indices (9% of revenue)

o    SPGI owns the well-known S&P equity indices, while IHS owns 17,000 bond and credit default swap indices under the iBoxx, iTraxx and CDX names. I’m not sure whether in the future the IHS indices will rebrand to the more valuable S&P name or whether we will see more multi-asset indices, but it seems clear there is a lot of overlap here. About 2/3rd of the money is earned based on AuM when the index is used by ETFs or Mutual Funds. with the rest earned on data fees or royalties paid by exchanges.

o    The customers are large and growing (Blackrock, Vanguard, State Street, etc) which leads to low pricing power. MSCI asset-linked fees declined from 3.63bps in 2013 to 2.82bps in 2019, a decline of 4% per year. This is probably similar for S&P. Most customers have announced self-indexing initiatives. How much less marketable is the iShares US large cap ETF versus the iShares S&P 500 ETF? For now, the continued flow into passive, offset by modest price concessions leads to double digit growth. I think this should at some point drop back to high single digits. In any case, any growth comes at an extremely high incremental margin.

-        Market Intelligence (Capital IQ) + Financial Services (34% of revenue)

o    Markit was founded as a company collecting pricing data on OTC-traded CDS. They are also the #2 on loan pricing in a market where they co-exist with Reuters.

o    Capital IQ only holds a 6% market share in an industry that includes Bloomberg (~33% share), Reuters (23% share), and Factset (4% share). As a Bloomberg user, I believe Bloomberg is begging its competitors to take share by insisting that its Microsoft DOS-era interface is still the way to go.

o    I believe adding proprietary data sources (see Transportation & Engineering and Commodities + Energy) and having pricing data would improve Capital IQ’s competitive position and SPGI’s Capital IQ is a great distribution channel for INFO’s data and analytics.

o    Most of the business is subscription based (Capital IQ was 97% subscription with a 95% renewal rate).

-        Transportation + Engineering (14% of revenue)

o    This business includes Automotive, Maritime, Product Design and Economics & Country risk. Most of the products here have no alternatives. IHS managed the IMO identifier of every large vessel and their import / export data is used to forecast 95% of global trade. Automotive OEMs need their data for forecasts on what type of vehicles (50k different type) are sold.

o    This business is very valuable as it is almost irreplaceable. However, the overlap with the rest of the business is minimal. I believe there are many use cases for their data that are not yet exploited, for instance financial market participants looking for alternative data sources. Capital IQ should help with the further distribution of this data.

o    Despite being mainly a fixed, recurring revenue stream, the end markets here are cyclical and transportation was not very resilient during the Covid pandemic. It’s a MSD – HSD growth and I think the combination with SPGI should give growth a boost. 

-        Commodities (Platts) + Energy (15% of revenue)

o    Platts provides energy industry participants with pricing data that are used to price financial products. Since these prices are deeply embedded in financial contracts, switching costs are prohibitively high. Petroleum is 69% of revenue, power & gas 18%, ag 8%, and petrochemicals 5%. This has been a 5% growth business, mainly due to the pricing power of Platts. I don’t see why future growth should be materially different.

o    The IHS business contains more industry related data services, such as valuation tools of oil wells, rigs, basins, vessels, refineries, that are useful when making capex decisions. This business has been more volatile due to the cyclicality in the end markets. Competition includes VRSK’s WoodMackenzie. Growth in IHS’ business has been MSD during the energy bear market and should be materially higher if energy has troughed, which I think it has.

Deal merits

https://investor.ihsmarkit.com/news-releases/news-release-details/sp-global-and-ihs-markit-merge-all-stock-transaction-valuing-ihs

-        SPGI / INFO promise cost synergies of 480m USD (7% of combined cost base) and 350m USD in revenue synergies, for a combined EBITA impact of 680m USD. Those synergies are in addition to cost cutting programs already in place at SPGI (120m USD targeted) and INFO (100 bps per year targeted). Honestly, 1 year into such a merger I usually can no longer distinguish between synergies, other cost cutting efforts and simple operating leverage. Data generally has lots of operating leverage (build it once, sell it many times) and margins should expand as long as the business grows. Top line growth of the combined entity is guided at 6.5% - 8.0% with 200 bps / year of margin expansion until 2023. 

Other than the ability to cut costs, there are some qualitative arguments to make why the combined entity is worth more than the 2 individual companies.

-        INFO’s proprietary transportation and resources data can be easily distributed through Capital IQ (300-400k users). Fund managers looking for alternative data, including in PE, are a good example of a still untapped market opportunity. Conversely, INFO’s Data Lake can be populated with SPGI data.

-        Combine INFO’s bond indices with S&P’s stock indices and potentially rebrand bond indices with the S&P name or create multi-asset (ESG) indices.

-        Pursue new initiatives in ESG and KYC together, which saves on future investments and gives a higher chance of success when combining SPGI’s RobecoSAM and Kensho analytics with IHS Data. 

The deal should be approved by H2 2021 and should face little approval risk. There is not as much overlap between the businesses as was the case with LSE – Refinitiv on bond trading and there are no privacy concerns as would be the case if Google or Facebook were involved. The biggest hurdle is probably shareholder approval by IHS since I believe SPGI gets the better deal.

Valuation

-        Target of 5b USD in FCF by 2023, of which 85% will be returned through dividends or buybacks.

-        14b USD of FCF generated in the 2021-2023 time frame.

-        Net Debt is currently 5b USD, while the 2.0-2.5x target on 7b USD of EBITDA by 2023 allows for 15b USD in debt capacity. Let’s assume management does the right thing and only spends this on M&A when it yields more than buybacks. So we’ll have 10+14=24b USD of buyback / M&A firepower, or 22% of the market cap.

-        Share count before repurchases should grow 0.5-1.0% per year because stock based comps is added back to get to the FCF figures just mentioned.

-        Share count could reduce by 20% by 2023 (or earnings growth will be faster due to M&A). 

I’m more concerned by the runway for growth, rather than how high exactly this growth is. I hope I have made a qualitative argument why most of the businesses have pricing power or untapped market opportunities, so even in 2023 this should be a MSD – HSD top line growth story with margin expansion. The compounder skeptics would point at the threat of multiple contraction if inflation and therefore rates pick up. However, most businesses here have built-in inflation hedges (the asset inflation kind, not the CPI kind) and growth should accelerate in such an environment. 

-        I do think 22x EV / EBITDA on 7b USD of 2023 earnings or ~30x FCF on 5b USD of 2023 is not unreasonable. That means a 140-150b USD market cap by 2023, on a share count that’s declined by 20%. That’s a 62-73% return in 3 years, or a 17-20% IRR. Note that at a 30x FCF multiple, a 2023 buyer could still buy this for a 3.3% FCF yield + HSD EPS growth for a >10% IRR, which is attractive even with treasuries paying 4%.

-        But what do I know. Usually the market disagrees with me when it comes to valuing the stocks I own. Even at a slightly lower multiple, the return from today’s level will still be adequate (>10%) as long as the company delivers on its earnings growth targets.

Catalyst

Catalysts

-        Shareholder rotation finishes

-        Company will deliver on synergy targets, which should result in double digit EPS growth.

-        Leverage is increased from 1x to 2.0-2.5x with excess capital returned to shareholders or deployed through accretive M&A.

 2 out of 3 catalysts are late 2021 or 2022 events so I might be a bit early.